Currys PC World store Oxford Street, London

Simple maths suggests Dixons Carphone plc may be cheap

Currys PC World store Oxford Street, London

Currys PC World store Oxford Street, London. Image credit: Dixons Carphone plc

Disclosure: Roland owns shares of Dixons Carphone.

Currys PC World owner Dixons Carphone (LON:DC) currently trades on just 5.5 times forecast earnings, with a prospective yield of 7.1%.

The stock also trades on a cheap-looking EV/EBITDA multiple of 3.2.

I think it’s fair to say that it’s either a value trap or too cheap to ignore. The question is which?

Pension deficit blues

One problem is that the group has a big pension deficit. The Dixons Retail scheme deficit was £589m at the end of April. That’s sucking up big deficit reduction payments. Dixons Carphone paid £43m into the scheme last year, putting a nasty dent in its otherwise impressive free cash flow.

My calculations suggest that the impact of this payment was to increase the trailing P/FCF ratio from 12 to around 17. However, I’ve seen several companies report sharp reductions in pension deficits recently, as bond yields have risen slightly. With a company of this size, I’m not overly concerned by the defecit.

The real question is sales (and margins)

In my view, the key to the investment appeal of this stock is the outlook for sales. Like all retailers, Dixons Carphone will experience operational gearing as sales rise and fall.

What this means is that due to retailers’ large proportion of fixed costs, if sales rise by 10%, profits typically rise by more than 10%. Similarly, if sales fall by 10%, profits might be expected to fall by more than 10%.

To try and get a better understanding of how operational gearing might affect Dixons Carphone, I’ve done some back-of-the-envelope calculations. My goal was to model what might happen if the firm’s sales fell by 10%. Please note this analysis was using basic estimated figures for my own purposes. It should not be considered as a forecast or guidance of any kind.

What I found was that a 10% fall in sales from the level seen last year might be expected to result in after-tax earnings falling by around 20%.

Consensus forecasts at the time of writing (Nov ’17) suggest the group may report adjusted earnings of 26.7p per share this year.

Reducing this by 25% (to give a greater margin for error) would give earnings of about 20p per share. This would put the stock on a forecast P/E of 7.7.

It would also still be enough to cover the dividend twice, although I still wouldn’t bet against a cut in such a scenario.

My verdict

I think it’s worth noting that the group’s most recent trading update showed an increase in like-for-like sales in all three of the group’s territories (UK & Ireland, Nordics and Greece).

Although some underlying factors are expected to result in a fall in profits this year, the group’s “core trading profitability” — presumably this means its main retail business — is expected to be in line with last year.

Although it’s not without risk, I think it’s reasonable to suggest the shares are quite cheap at the current level of less than 160p. I may add some more to my holding.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

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